Investing in Beauty and Personal Care? Look for Cash!

A lot has been written about the slow pace of economic recovery in the U.S. with unemployment levels at close to historical highs at 9.4% (as of December 2010) set in contrast to the feverish growth of emerging markets.It then comes as no surprise that most of the big players in the beauty and personal care industry such as L'Oreal ( LRLCY ), Estee Lauder ( EL ), Revlon ( REV ), Avon ( AVP ), Procter & Gamble ( PG ), Unilever (UL), Colgate (CL) and Kimberly Clark (KMB) are increasing their presence in growing markets like China, India and Latin America.

As double-digit growth rates in emerging economies seem more attractive than their home markets in the U.S. and Western Europe, these companies have the challenge of how to focus their resources. And while all players can focus on growing in these markets, some are better placed to exploit these than others.

But what does it mean for the average investor?

For an investor, a stock is worth its ability to put cash back into his or her pocket. Stocks are not bought and sold by profits or forecasts and dividends are not driven by analysts upgrades like share prices can be - and so it pays to follow the actual cash!

Here we've examined three parameters: (i) the cash conversion ratio (measured by free cash flows % total revenues), (ii) dividends to free cash flows ratio (cash dividends as a % free cash flows) and (iii) revenue growth projections (2010-15 CAGR) to evaluate our estimates of the cash position in the leading players in the beauty and personal care industry.

Why Cash Conversion Ratio?

The cash conversion ratio shows how efficiently a company converts sales to cash. This implicitly captures the operational efficiencies and can avoid tax adjustments that could have misleading impacts on net income. A high EBITDA margin, which could be on account of high profit margins or better technology, leads to a higher cash conversion ratio unless interest payments on outstanding debt eat into these cash flows.

We estimate that Procter & Gamble and Colgate-Palmolive will have better cash conversion ratios than their peers at around 14% in the coming years. Avon has a low cash conversion ratio of 6%, which highlights the need for improvements in its operational efficiencies relative to peers.

Estee Lauder has a cash conversion ratio of around 4% but is already on track to double it in the coming years by pursuing improvements in operating margins.

Why Dividend to Free Cash Flow Ratio and Revenue Growth?

The company might be generating cash flow but many investors like to see management pay this cash to shareholders and many investors take the dividend policy into consideration before buying stocks, especially in consumer related sectors. We decided to look at dividend to free cash flow to compare how much companies are paying out of the cash flow available.

We also include expected revenue growth to give an indication of what growth should look like in the coming years. Here Avon, Colgate and Estee Lauder top their peers with expected growth of mid to high single digit revenue growth.

On these metrics, Revlon raises our concerns. We foresee low revenue growth in the coming years at around 2% and the company is trying to reduce its debt and so is unable to invest in growing its business, for example through marketing, relative to peers. Unilever has modest sales conversion to cash flow but has a higher payout ratio than many if its peers making it desirable for dividend hungry investors.

If we weighted these three factors equally, Colgate, P&G and L'Oreal look to have a nice balance of free cash flow generation, expected sales growth in mid to high single digits and are expected to pay out somewhere close to half of their free cash flow by our estimates.

Below you can scroll through our sideshow for P&G to see our key drivers and visit our site to see the companies mentioned.

See our full estimates for these companies.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.